The standard rules of a 401K retirement plan indicate that a 401K would have single ownership by an individual. The contributions and earnings in a 401K are tax deferred until withdrawn by the owner. Any withdrawals made before the age of 59 ½ are subject to a ten (10%) percent Early Withdrawal penalty period. The financial institution that holds the 401K is required to withhold a minimum of twenty (20%) percent for Federal Income Tax on each 401K withdrawal.
It is true that a 401K can be borrowed against without a tax consequence by the owner, so long as the owner participant is still employed by the same company and continues to make payments to the 401K loan in order to pay it off in full. It the owner or participant should leave the company or stop making payments, the 401K loan is then considered distribution and subject to all taxes and penalties.
In the context of a divorce, when there is a division of assets that requires a division of the monies in a 401K, a 401K may be transferred from one spouse to another via a Qualified Domestic Relations Order (QDRO.) All or part of the value of the 401K may be transferred pursuant to the QDRO, and the value of the account may be established at different points in time. The amount or portion transferred to the non-owner spouse (alternate payee) is no longer considered a 401K if that individual is not employed by the company who maintains the retirement plan. That portion transferred to the alternate payee becomes an IRA, or an Individual Retirement Account, for that spouse. That portion of money is then subject to all of the IRA rules, including a financial institution being required to withhold the minimum of ten (10%) percent for Federal Income Tax in the event monies are withdrawn from that IRA.
At the time of a division by a QDRO, it is also important to note that cash could be withdrawn from the 401K by the receiving spouse without the consequences of the ten (10%) percent early withdrawal penalty so long as the parties do so per the QDRO. This is clearly beneficial to parties who wait for the court order by QDRO, however, for those parties who try to accommodate each other during the pendency of divorce and prior to the approval of the QDRO and resolution of the divorce, by withdrawing from the 401K directly, they will end up paying unnecessary taxes and early penalty withdrawals. When the issue of access to money from a 401K arises during the pendency of a divorce it is important for the parties to acknowledge that in addition to the rules related to 401Ks as to taxation and withdrawal penalties, there is also the income tax component that needs to be figured in when deciding how the monies should be withdrawn.
Consultation with an accountant, and preferably one who specializes in divorce matters, is of paramount importance for the parties. Most attorneys with experience in family law will be able to refer the clients to an accountant or divorce financial analyst who has the appropriate experience and knowledge in order to calculate alternatives for the parties to determine which is the best way for a withdrawal or division of monies from a 401K.
by: Julie A. Dialessi-Lafley, Esq.
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